COMPANIES UK: Hedge funds fail to live up to their name
By: By Chris Hughes and Anuj Gangahar, Financial Times
Published: Jul 13, 2006
Hedge funds are in the dock again. They stand accused not of fraud or bullyingcompany management or "locust"-like behaviour.
The charge is more fundamental. It is that hedge funds increasingly look like the long-only funds that they are meant to beat - only with vastly inflated fees.
The market volatility of May and June has called into question the common claim that hedge funds can insulate their investors from the pain of a falling stock market.
Many funds tracked the market downwards. Given the flexibility of their strategies - which allow them to invest across a variety of assets and to bet on stock prices declining - they should have been profiting from all the turmoil.
The worst offenders are found among equity long-short hedge funds, the predominant strategy among the world's estimated 10,000 hedge fund firms. With this strategy, the hedge fund manager buys favoured stocks while simultaneously short-selling other stocks he or she believes will fall.
In May, equity long-short funds were down 2.2 per cent, according to Hedge Fund Research, with a further half percentage point drop in June.
These average figures mask large double-digit falls at some equity long-short funds in the period, according to prime broking sources.
True, not many equity long-short funds claim to be immune to the wider market. Some even tell investors how much they could lose in a month given the risks they run.
But the negative performance is hard to excuse.
Investors typically pay a 2 per cent management fee plus performance fees on top, usually worth 20 per cent of the investment gains. They cough up partly because they expect equity long-short funds to be run some sort of hedge against market falls.
What went wrong? The problem goes back to the turn of the year, when many equity long-short hedge funds concentrated their portfolios among a handful of investments in companies exposed to global growth, such as precious metals and energy groups, according to prime broking sources. Long positions considerably outweighed shorts.
In many cases, these positions were highly leveraged, using borrowed money to increase the size of their bets. But they were not hedged with offsetting positions that could cushion the blow if the market went awry.
Hedge funds call this momentum trading. It was a simple bet that the bull market that began in 2003 would continue, driven by company earnings upgrades.
May's US inflation scare acted as a catalyst to break the momentum. That then left equity long-short funds with leveraged exposure to a falling market.
Some hedge fund managers say they pursued this momentum trade under pressure from their own investors, who were complaining that they were underperforming tracker funds by carrying too many short positions.
But others say the trade was partly based on fundamental analysis that stocks were cheap, given the strength of the global economy.
David Yarrow, founder of Clareville Capital, the hedge fund group, says: "There is no fear like the fear of missing out [on a rising market]. The need to participate [as the market went up] meant there was a degree of correlation. This is what happens when you have to feed the monster of monthly performance."
Mr Yarrow says hedge funds found it hard to hedge their positions as the market momentum was also driving up the stocks that would be been sold short as a hedge. "It is very difficult tohedge when there is a lotof positive momentum around," he says.
Crispin Odey, founder of Odey Asset Management, agrees. "Even if you were running a balanced book, you got whacked," he says.
Odey was down 3.6 per cent in May but only 1 per cent in June.
But not all hedge fund managers are so sympathetic. There were red flags that should have alerted hedge fund managers to the risks they were running.
London-based Bailey Coates, for example, liquidated its fund last year after making ill-judged concentrated leveraged bets on US equities.
"I do get the sense that hedge funds are outright long, in which case they have no right to charge big fees," says an executive at a London-based hedge fund operating a "market-neutral" strategy.
Market-neutral funds aim to avoid correlation with the performance of the market. "It was frustrating in the first quarter to see [the momentum funds] doing so well," the executive said. "But there is no way you can have that upside without pain when the markets fall."
Mr Odey says: "I think it's a fair and proper charge against the industry [that investors are paying high fees for long-only strategies]."
Moreover, there is the suspicion that a lot of hedge funds were doing well only because they set up during the recent bull market and their lack of stock-picking prowess is only now being exposed. "You need a shake-out to see whether these guys are any good," says one hedge fund manager.
Meanwhile, people close to the market say that, as a community, hedge funds have still not grasped how to hedge properly.
Many will hedge a long portfolio of stocks simply by short-selling futures over an entire index.
"That is lazy hedging but it's probably what half of all hedge funds do," says one prime broking source.
One explanation for hedge funds' lack of skill in hedging is that they are largely staffed by former long-only managers from the big institutional fund managers. Their experience of short-selling and risk management is not therefore terribly advanced.
"How many of these hedge funds are really just long-only managers?" asks Mr Odey.
It would, however, be wrong to tar all hedge fund managers with the same brush.
Merger arbitrage strategies and, predictably, short-biased funds fared well in May and June. And so too did market-neutral hedge funds - proving that genuine hedging does, indeed, exist for those who know how.
© Copyright The Financial Times Ltd
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